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Asymmetric sensitivity of CEO cash compensation to stock returns: A discussion
ARTICLE IN PRESS
Journal of Accounting and Economics 42 (2006) 193–202 www.elsevier.com/locate/jae
Asymmetric sensitivity of CEO cash compensation to stock returns: A discussion$ Patricia M. Dechow Stephen M. Ross School of Business, University of Michigan, 701 Tappan Street, Ann Arbor, MI 48109 1234, USA Available online 22 June 2006
Abstract Leone, Wu, and Zimmerman [Leone, A., Wu, J., Zimmerman, J., 2005. Asymmetric sensitivity of CEO cash compensation to stock returns. Journal of Accounting and Economics, forthcoming] find that cash compensation (salary and bonus) is more sensitive to price decreases than to price increases. The authors interpret this result as consistent with Boards of Directors exercising discretion to reduce costly ex post settling up in cash compensation. I discuss potential alternative explanations. Specifically, the design of bonus contracts and the placement of the upper bound, and the effect of the Internal Revenue Code Section 162 (m) that limits the deductibility of cash compensation over one million dollars. I also link their results to the managerial power and rent extraction perspective. r 2006 Elsevier B.V. All rights reserved. JEL classifications: G34; J33; M40 Keywords: Management compensation; Bonus contracts; Pay sensitivity; Managerial power
1. Introduction The objective of Leone et al. (2005) (LWZ) is to examine the ex post settling up problem. The idea behind the paper is that due to the ex post settling up problem, cashcompensation contracts will have asymmetric pay off functions. To clarify the nature of the ex post settling up problem, consider the following contract: $
I am grateful for the comments of Katherine Guthrie, Venky Nager, D.J. Nanda, Doug Skinner, Richard Sloan, and the research help of Weili Ge. Tel.: +1 734 764 3191; fax: +1 734 936 0282. E-mail address: [email protected]. 0165-4101/$ - see front matter r 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.jacceco.2005.11.001
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1.1. Symmetric contract
Bonus is 10% of increases in firm value (unrealized gain) Bonus is 10% of decreases in firm value (unrealized loss)
Now suppose the CEO puts in effort and increases the value of the firm by $100 (due to signing a lucrative contract that the owners believe is valuable and will lead to increases in future cash flows). Under the symmetric contract, the CEO will earn $10 cash immediately. Now, consider what happens in the next period when the contract falls through and the value of the firm drops by $100 (no value was created after all). The CEO owes the owners $10. If the CEO has resigned in the interim period, it will be difficult, if not impossible, for the owners to recover the $10 bonus from the CEO. This is the nature of the ex post settling up problem. There certainly seems to be anecdotal evidence that it is difficult and costly to force management to return undeserved bonuses. Two examples illustrate this point: The New York bank’s activist fund introduced a proposal at Computer Associates International Inc.’s annual meeting last summer asking the board to ‘‘undertake to recoup money that was not earned or deserved’’ following an accounting scandal at the big software maker. It was the first shareholder resolution urging pursuit of executive pay improperly doled out because of restated earnings, according to Mr. Hitchcock. Some stockholders at the meeting berated CA Chairman Lewis Ranieri for not doing more to recoup bonuses. Nevertheless, the resolution lost by a 3-to-1 margin. y last year, the SEC secured $22 million in penalties, disgorgement from compensation and stock sales, and interest from six former Xerox Corp. executives who allegedly participated in a massive fraud. But Xerox said it was required to indemnify the executives and absorbed the tab for all but about $3 million. The agency has attempted to prevent such reimbursements in subsequent settlements. Xerox restated five years of results in 2002, saying $1.41 billion in pretax income had been overstated and $6.4 billion in equipment revenue was wrongly booked. (‘‘Recovering Bonuses Remains Infrequent Despite Emphasis On Corporate Reform,’’ by Joann S. Lublin and Charles Forelle, Staff Reporters of THE WALL STREET JOURNAL, 12 October 2004; p. C1) These examples illustrate that some compensation contracts do not adequately consider the ex post settling up problem. The Sarbanes-Oxley (2002) Act encourages firms to write provisions into compensation agreements requiring executives to return bonuses on restated numbers. LWZ argue that the optimal cash compensation contract will consider the ex post settling up problem and will not be symmetric in gains and losses but instead will give less weight to gains. Consider the following contract: 1.2. Asymmetric contract
Bonus is 5% of increases in firm value (unrealized gain) Bonus is 10% of decreases in firm value (unrealized loss)
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This contract is more sensitive to downside risk. When the CEO signs a lucrative contract and firm value goes up by $100, the CEO receives a bonus of $5. Now, consider what happens in the next period when the contract falls through and the value of the firm drops by $100 (no value was created after all). The bonus is 10% of the decrease in firm value, so the CEO owes the owners $10. If the CEO has resigned in the interim period, it may be difficult for the owners to recover the bonus from the CEO. However, the owners have only lost $5 rather than the $10 they would have lost under the symmetric contract. Thus, the asymmetric payoff function reduces agency costs related to ex post settling up. The asymmetric nature of the contract subjects the CEO to greater risk. Thus, the CEO would probably require a higher expected wage to accept the asymmetric contract. Optimal contracting typically assumes a risk-averse manager and risk neutral owners and the objective of the contract is to provide incentives for the manager to increase firm value, but at the same time shield them from risk. In contrast, this contract exposes the CEO to more downside risk and less upside benefit. LWZ also consider equity incentives (options and restricted stock grants), and suggest that these will have symmetric payoff functions because they have built in safe guards against the ex post settling up problem. In the example above, assume the CEO receives an option grant (at the money) when he signs the lucrative contract in the first period (and increases firm value by $100). In the next period when firm value decreases by $100, his options will be out of the money and so the owners do not lose. If he leaves in the interim and his options have not vested, then the owners also do not lose. 2. Predictions and tests In order to test whether cash compensation contracts (salary and bonus) are asymmetric in expected gains and losses, LWZ first need to obtain a proxy for unexpected gains and losses. Their paper considers various measures of unexpected/expected gain or loss. They suggest that market-adjusted stock returns reflect changes in expectations about future cash flows and so positive returns are indicative of a CEO creating value (unexpected gains), while negative stock returns are indicative of a CEO who has reduced value (unexpected losses). These are called ‘‘good news’’ and ‘‘bad news’’ firms, respectively. LWZ predict that CEO cash pay is more sensitive to stock returns when returns are negative. They set D ¼ 1 when stock returns (R) are negative. They run the following regression (reported in Table 4): D lnðCash Compit Þ ¼ b0t þ bit þ b2 Rit þ b3 DROAit þ b4 Dit Rit þ b5 Dit DROAit þ controls:
ð1Þ
They predict a positive coefficient on b2, b3, and b4 they have no prediction for b5. Specifically, they find a positive coefficient on b4 consistent with cash compensation being more sensitive to negative returns (unexpected losses). This result is robust when the authors use raw returns or industry-adjusted returns. They also regress: D lnðEquity Compit Þ ¼ b0t þ bit þ b2 Rit þ b3 DROAit þ b4 Dit Rit þ b5 Dit DROAit þ controls:
ð2Þ
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They predict that b2 will be positive and that b4 will equal to zero (unfortunately, they predict a null result for b4 which makes interpretation difficult). Their results are consistent with their predictions. LWZ’s results are very interesting and they have done a multitude of tests to ensure that the result is robust. Unfortunately, their cross-sectional tests examining situations where the ex post settling up problem is more severe (such as when the CEO is close to retirement) do not produce significant results, bringing into question whether the ex post story is what is driving their results. LWZ recognize this concern and point out that this suggests that the ex post settling up explanation is a plausible but not compelling explanation for the asymmetry. To summarize, consistent with ex post settling up, the authors find that salary and bonuses (cash compensation) are more sensitive to stock price decreases than to stock price increases. I am confident that this result is robust. Therefore, my discussion will explore alternative potential explanations for their empirical findings. 3. Optimal contracting perspective and the importance of ex post settling up Under optimal contracting theory the objective is to provide incentives for managers to act in the interest of the owners to maximize firm value, while minimizing agency costs. An important consideration therefore is which is a dominant concern for the owners:
Do the owners want to provide incentives to encourage the CEO to take the right action to increase firm value (provide a carrot)? or Do the owners want to penalize the CEO fully and immediately when things go wrong (use a stick)? Consider the type of features included in typical compensation contracts:
Base salary—receive no matter what happens; Bonus—lower bound and upper bound features; Stock options—issued at the money, have zero value when price drops below the exercise price. Can be reissued/repriced when stock prices fall; Restricted stock—payoff when performance metrics are met; Golden parachutes—provide payments to CEOs when company is a target to a hostile takeover.
The features of these contracts appear to be consistent with risk neutral owners providing incentives to limit managers’ downside risk so as to encourage them to take on risky positive net present value projects. Theory suggests that the level of expected compensation needs to be set higher to attract a manager (who has competing job opportunities) to work for a firm that offers incentive compensation (due to the uncertainty of the payoffs). Therefore, by limiting the downside risk, owner can reduce the overall expected pay to the manager. If penalizing CEOs for unexpected losses is of first-order importance, would not we observe contractual features explicitly outlining the asymmetric pay-off function? Ex post settling up is certainly an important problem, but I think it is likely to be of second-order importance in the design of compensation contract. So then, what explains LWZ’s findings? Below I discuss a few alternatives.
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4. The design of compensation contracts 4.1. The bonus contract: the mystery of the non-GAAP earnings number that includes unrealized losses Bonus contracts typically state that the bonus is a percentage of an earnings metric such as return on assets or return on equity. There is usually no explicit mention of stock price performance in these contracts. Yet LWZ are suggesting that the board of directors identify and include unrealized losses (not reflected in GAAP income) in determining the bonus. Where do compensation committees find this number? The basic premise of this prediction seems at odds with results documented in prior research that suggests that boards filter out ‘‘unexpected or unusual’’ negative items in earnings. Dechow et al. (1994) find that non-recurring restructuring charges are filtered out of CEO compensation. They suggest that this is consistent with boards encouraging CEOs to take unpleasant value-enhancing actions that reduce current earnings. Gaver and Gaver (1998) have a more sinister view. They document that losses are filtered out of CEO pay while gains are included in CEO pay. They find that the transitory nature of the item is unimportant. They suggest that CEOs opportunistically lobby the board to filter out losses but not gains from earnings. If CEOs are not penalized for recognized losses in earnings, why would CEOs tolerate the Board penalizing them on a non-GAAP earnings number that includes unrealized losses? Why is this mysterious non-GAAP earnings number not mentioned in proxy statements? Of course, compensation committees could be using their discretion to reduce bonuses even when the target is met. However, there are alternative explanations for this finding. Holthausen et al. (1995, Table 3) provide statistics on how bonuses are set using a proprietary data set that gives details on bonus contracts. They report that the average target bonus is set at 55% of salary and is capped at 88% of salary. The threshold bonus (lower bound) is set at 7% of salary. This is presented graphically in Fig. 1. They point out that the CEO on average makes the target bonus (i.e., targets are set so that the CEO expects to receive a bonus of 55% of salary). The features of the contract indicate that CEO expected pay is set closer to the upper bound. It is not an equal distance from the upper and lower bound. Therefore, as shown in Fig. 1, cash compensation is less sensitive to upside potential because of the greater likelihood of hitting the upper bound. Indjejikian and Nanda (2002) document a similar finding. They report that target bonuses are biased so that they are on average easy to achieve.1 Empirically, this means that more CEO pay observations exceed the target than are below it. In Table 2 of Leone et al. (2005) have more observations with negative market-adjusted returns (5,749) than with positive market-adjusted returns (4,109), suggesting that some of the negative realizations correspond to managers actually beating their bonus targets. In contrast, the positive returns are likely to reflect managers beating their targets and hitting the upper 1 Indjejikian and Nanda (2002) also find that targets are less likely to be adjusted upwards (after a target is exceeded), then downward (after a target is missed). They suggest that this asymmetric adjustment process will create better future incentive alignment for managers who miss their target (although this asymmetric function also appears to be consistent with management opportunism). This asymmetric adjustment is difficult to reconcile with the ex post settling up story.
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100%
Bonus (% Salary)
88% ∆ = 33% 55% Cash compensation less sensitive to upside due to greater likelihood of hitting upper bound
∆ = 48% 7% Lower Bound
Target ROA
∆ ROA= - 5%
Upper Bound ∆ ROA= + 5%
Fig. 1. A typical compensation contract (see Holthousen et al., 1995).
bound, where the slope of the bonus function is zero. Consequently, CEOs with ‘‘bad news’’ are more likely to be in the incentive zone than managers with ‘‘good news.’’2 In summary, a feature of bonus plans is that they are set to be more sensitive to downside risk. Firms that do well are likely to have higher ROA and returns, and are therefore more likely to hit the upper bound. Firms that do poorly have lower ROA and negative returns BUT are less likely to hit the lower bound. In other words the significant coefficient on DR may not be due to Board’s considering unrealized losses (having a mysterious non-GAAP earnings number that includes unrealized losses) when determining the CEOs cash compensation. Compensation committees could be mechanically applying the bonus formula and LWZ could just be documenting this feature of the contract. 4.2. Equity sensitivity to changes in stock prices As shown in Eq. (2), LWZ find that b4 is insignificant and suggest that this implies a symmetric payoff for unrealized gains and losses. They argue that this is consistent with their ex post settling up story. LWZ measure equity compensation as stock options and restricted stock granted during the year. CEOs wealth from stock options is equal to the total value of all his options outstanding (grants plus options that have vested but not expired). The CEO’s sensitivity to stock price movement is equal to the change in value of all the options he owns to a change in price. Fig. 2 provides the payoff function to an option. Executive options are usually granted at the money (exercise price equal to the market price). As can be seen from Fig. 2, when the stock price is close to the exercise price, the change in the value of the option (its delta) is more sensitive to upward movements in stock price than to downward movements in price. 2
Another possibility for the greater sensitivity of bonuses to negative returns relates to the performance metric used in the bonus contract. Compensation committees could sensitize CEO pay to changes in total firm value (debt plus equity). When the CEO increases firm value, his bonus will increase, and the shareholders benefit disproportionately (due to the fixed pay-off function of debt). When the CEO decreases firm value, his bonus will decrease, but the shareholders share some of this decrease in value with debt holders. As a consequence, bonuses would be more sensitive to decreases in stock returns.
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50 45 40
Prior
35 30
Starting point: X =current stock price
25 20 15 10 5 0 0
5
10
15
20
25
30 35 40 Option Value
45
50
55
60
65
70
Fig. 2. Evaluating stock compensation. Stock options granted at current stock prices: implies that option value is much more sensitive to upward changes than to downward changes in price (i.e., D is larger for upward movements).
If LWZ had used the change in the total value of options used in CEO equity compensation rather than grants, then we would expect the coefficient on DR (b4) to be negative (less sensitive to downside stock movements). 4.3. Combining cash and equity compensation and considering total compensation When considering the optimal contract, the objective is to provide incentives for managers to maximize firm value. Stock options and restricted stock provide CEO pay with upside sensitivity (but limit downside risk), the bonus is set to provide the CEO pay with some downside sensitivity (limits the upside benefit). When we combine both components of compensation and analyze total compensation, it appears that contracts are designed to provide a symmetric pay-for-performance sensitivity. This suggests that an alternative explanation for LWZ’s results is that optimal contracts provide both upward and downward risk sensitivity to value, but the sensitivities come from different parts of the overall pay package. 5. Managerial power perspective: outrage and camouflage A growing area of compensation literature investigates an alternative explanation to optimal contracting for the design features in executive compensation. Bebchuck et al. (2002) point out that many features of compensation contracts can be explained in terms of managerial power and rent extraction (skimming). This view argues that CEOs have power to influence their own pay, and they use that power to extract rents subject to two constraints: the outrage factor and their ability to camouflage their pay. Bebchuk et al. (2002, p. 786) note that at some point even the most loyal director will refuse to approve the compensation package, or shareholders may seek to replace the CEO (the outrage factor). However, the outrage factor can only occur when there is widespread recognition that the level of compensation is too high. Bebchuk et al. (2002, p. 788) note that a large extraction of rents will not cause harm if it can be packaged or camouflaged so that it is not
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readily apparent. They argue that compensation consultants help justify large pay packages and certain features of stock options (e.g., providing too many) help with camouflage. The point is that under the management power perspective, one no longer views the board as independent acting in the interest of owners. Instead, the board is happy to satisfy the CEO subject to not causing outrage that can be costly to the directors’ reputation and wealth. Under this view, compensation contracts are designed to give the CEO as many carrots as possible, in ways that do not cause undue scrutiny. An interesting question is how well do the results documented by LWZ fit into this framework? 5.1. Section 162 (m) implications for cash compensation LWZ’s sample consists of firm-years between 1993 and 2003. In the early 1990s, there was a public outcry against ‘‘excessive’’ executive compensation. This resulted in several regulatory changes including the SEC rule change in 1993 requiring enhanced disclosure on executive compensation and the enactment of tax legislation limiting the deductibility of non-performance-related compensation over one million dollars [Section 162(m) of the Internal Revenue Code]. The goal of the new SEC disclosure requirements was to make compensation disclosures clearer and more concise. Congress never intended for Section 162(m) to be a revenue-raising provision, but instead Congress hoped to change corporate behavior. Whether cash bonuses are treated as performance-based depends on a number of factors. Balsam and Ryan (1996) note the following (italics added) To qualify for the performance-based exception under section 162(m), companies must develop a performance-based compensation plan that is based on the executive’s attainment of one or more performance goals that were established exante by a compensation committee composed of independent directors. The performance goals must be based on objective formulae and the material terms of the plan must be disclosed to and approved by shareholders. The compensation committee, which has the discretion to award less, but not more than the objectively determined amount, must certify that the performance goals have been met before payment is made. In other words, if Boards want to include ‘‘unrealized losses’’ or negative news to adjust bonuses down, they can. If they want to include ‘‘unrealized gains,’’ or positive news to adjust bonuses up, they cannot (they have to instead adjust some other part of the compensation package). Therefore, an alternative explanation to the ex post settling up story for the greater sensitivity of cash compensation to ‘‘bad news’’ is that Boards want to be able to claim that the bonus compensation paid to CEOs is ‘‘performance based’’ and tax deductible (perhaps because of outrage concerns). This results in them only having discretion on the downside, due to section 162 (m). Perry and Zenner (2001) point out that the actual dollar cost of losing the tax deductibility of the pay is small and immaterial to many firms. Therefore, one could argue that the cost itself is unlikely to deter extra cash compensation and so section 162 (m) could not be driving LWZ’s results. However, Perry and Zenner (2001, p. 8) state: The Investor’s Business Daily of March 10, 1995 presents some data from a Towers Perrin survey illustrating why firms are concerned about 162(m). The survey reports
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that 87% of the firms surveyed intended to implement 162(m) changes for positive shareholder relations while only 43% of the firms mentioned that financial (tax) considerations were important. LWZ report that the average manager in the sample is paid $1.2 million in cash compensation, with managers of bad news firms paid 1.17 million and managers of good news firms paid 1.4 million. If the $1 million dollars threshold is the number that is likely to cause investor outrage, then many of the Compensation Committees in LWZ’s sample are likely to prefer to substitute away from cash compensation towards equity-based incentives when there is a desire to provide more compensation to the CEO. In other words, outrage concerns over ‘‘excessive’’ cash pay could also act as a cap on CEOs cash pay. This in turn could lead to a less sensitive pay-for-performance relation in the positive stock-return sample. 5.2. Other avenues of research investigation the managerial power perspective for ‘‘bad news’’ firms Paying excessive cash compensation is a very visible performance metric that is not easily camouflaged and is likely to cause considerable outrage when the firm is doing poorly (why is the CEO getting a pay rise while others are losing their jobs!). One way for the CEO to get around this problem is to substitute other forms of pay (airplanes, stock options, gym memberships, etc.) for cash. It is difficult to determine from LWZ’s descriptive statistics (Table 2) whether there is a substitution effect going on for firms with negative stock price performance. Do CEOs of ‘‘bad news’’ firms lose some cash compensation but make it up through larger option grants that are less observable to outsiders? The prior version of the paper (presented at the conference) had a smaller sample size (3,707 firms) and LWZ’s descriptive statistics suggested that cash compensation and equity compensation slightly increased for ‘‘bad news’’ firms but stock compensation increased by a much greater percentage. In this version of the paper (sample size of 9,858) the results present a different picture. It would be interesting to know more about the distribution of the change in equity and cash compensation for the ‘‘bad news’’ firms. In what proportion of the firms does there appear to be substitution of equity compensation for cash compensation and are these firms most likely to be subject to outrage? It would also be interesting for LWZ to investigate whether CEOs whose cash compensation is most sensitive to negative stock price performance are ones where ‘‘outrage costs’’ are high (perhaps firms that are already under scrutiny by the media or investor advocate groups). Another interesting extension would be to examine whether board composition affects the relation. For example, are firms in which the CEO has significant power over the board, more likely to substitute equity compensation for cash compensation when the firm is doing poorly? 6. Conclusion Leone et al. (2005) identify an interesting empirical fact. They find that after controlling for earnings, cash compensation is more sensitive to negative stock returns than to positive stock returns. This result is consistent with their prediction that the pay-for-performance relation is stronger for ‘‘bad news’’ firms because of the ex post settling up problem.
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My discussion takes this result as ‘‘given’’ and considers alternative explanations for their findings. I question whether the ex post settling up problem is of first-order importance in explaining the authors’ findings. Optimal contracting theory suggests that (risk neutral) owners want to provide incentives to (risk averse) managers to maximize firm value, subject to minimizing agency costs. In order to align the manager’s interest, the owners want to provide incentives that encourage managers to take actions to maximize firm value. The optimal compensation contract will typically include several components to achieve this goal. Bonus contracts appear to be designed to provide executives with limited upside and more downside risk, while equity contracts appear to be designed to give executives limited downside and more upside risk. Taken together, this suggests that total executive compensation is sensitive to both upward and downward movements in value. The source of the sensitivity is just derived from different components of the package. I also explore the managerial power perspective (e.g., Bebchuk et al., 2002). In the early 1990s, public outrage over excessive executive compensation resulted in two major regulatory changes. First, in 1994 the SEC required more disclosure of compensation. Second, Congress passed rule 162 (m) that made non-performance based compensation over one million dollars non-tax deductible. The motivation for this legislation was to encourage more pay-for-performance. I discuss several reasons why this legislation is likely to cause a stronger pay-for-performance relation for the ‘‘bad news’’ firms. In summary, this is a very interesting and thought-provoking paper that opens a number of opportunities for future research. References Balsam, S., Ryan, D., 1996. Limiting executive compensation: the case of CEOs hired after the imposition of 162(m). Working Paper, Temple University. Bebchuck, L.A., Fried, J.M., Walker, D.I., 2002. Managerial power and rent extraction in the design of executive compensation. The University of Chicago Law Review 69, 751–846. Dechow, P., Huson, M., Sloan, R., 1994. The effect of restructuring charges on executives’ cash compensation. Accounting Review 69, 138–156. Gaver, J.J., Gaver, K.M., 1998. The relation between nonrecurring accounting charges and CEO cash compensation. The Accounting Review, 235–253. Holthausen, R., Larcker, D., Sloan, R., 1995. Annual bonus schemes and the manipulation of earnings. Journal of Accounting and Economics 19, 29–74. Indjejikian, R.J., Nanda, D.J., 2002. Executive target bonuses and what they imply about performance standards. The Accounting Review 77 (4), 793–819. Leone, A., Wu, J., Zimmerman, J., 2006. Asymmetric sensitivity of CEO cash compensation to stock returns. Journal of Accounting and Economics 42, 167–192. Perry, T., Zenner, M., 2001. Pay for performance? Government regulations and the structure of compensation contracts. Journal of Financial Economics 62, 453–488.
Journal of Accounting and Economics 42 (2006) 193–202 www.elsevier.com/locate/jae
Asymmetric sensitivity of CEO cash compensation to stock returns: A discussion$ Patricia M. Dechow Stephen M. Ross School of Business, University of Michigan, 701 Tappan Street, Ann Arbor, MI 48109 1234, USA Available online 22 June 2006
Abstract Leone, Wu, and Zimmerman [Leone, A., Wu, J., Zimmerman, J., 2005. Asymmetric sensitivity of CEO cash compensation to stock returns. Journal of Accounting and Economics, forthcoming] find that cash compensation (salary and bonus) is more sensitive to price decreases than to price increases. The authors interpret this result as consistent with Boards of Directors exercising discretion to reduce costly ex post settling up in cash compensation. I discuss potential alternative explanations. Specifically, the design of bonus contracts and the placement of the upper bound, and the effect of the Internal Revenue Code Section 162 (m) that limits the deductibility of cash compensation over one million dollars. I also link their results to the managerial power and rent extraction perspective. r 2006 Elsevier B.V. All rights reserved. JEL classifications: G34; J33; M40 Keywords: Management compensation; Bonus contracts; Pay sensitivity; Managerial power
1. Introduction The objective of Leone et al. (2005) (LWZ) is to examine the ex post settling up problem. The idea behind the paper is that due to the ex post settling up problem, cashcompensation contracts will have asymmetric pay off functions. To clarify the nature of the ex post settling up problem, consider the following contract: $
I am grateful for the comments of Katherine Guthrie, Venky Nager, D.J. Nanda, Doug Skinner, Richard Sloan, and the research help of Weili Ge. Tel.: +1 734 764 3191; fax: +1 734 936 0282. E-mail address: [email protected]. 0165-4101/$ - see front matter r 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.jacceco.2005.11.001
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1.1. Symmetric contract
Bonus is 10% of increases in firm value (unrealized gain) Bonus is 10% of decreases in firm value (unrealized loss)
Now suppose the CEO puts in effort and increases the value of the firm by $100 (due to signing a lucrative contract that the owners believe is valuable and will lead to increases in future cash flows). Under the symmetric contract, the CEO will earn $10 cash immediately. Now, consider what happens in the next period when the contract falls through and the value of the firm drops by $100 (no value was created after all). The CEO owes the owners $10. If the CEO has resigned in the interim period, it will be difficult, if not impossible, for the owners to recover the $10 bonus from the CEO. This is the nature of the ex post settling up problem. There certainly seems to be anecdotal evidence that it is difficult and costly to force management to return undeserved bonuses. Two examples illustrate this point: The New York bank’s activist fund introduced a proposal at Computer Associates International Inc.’s annual meeting last summer asking the board to ‘‘undertake to recoup money that was not earned or deserved’’ following an accounting scandal at the big software maker. It was the first shareholder resolution urging pursuit of executive pay improperly doled out because of restated earnings, according to Mr. Hitchcock. Some stockholders at the meeting berated CA Chairman Lewis Ranieri for not doing more to recoup bonuses. Nevertheless, the resolution lost by a 3-to-1 margin. y last year, the SEC secured $22 million in penalties, disgorgement from compensation and stock sales, and interest from six former Xerox Corp. executives who allegedly participated in a massive fraud. But Xerox said it was required to indemnify the executives and absorbed the tab for all but about $3 million. The agency has attempted to prevent such reimbursements in subsequent settlements. Xerox restated five years of results in 2002, saying $1.41 billion in pretax income had been overstated and $6.4 billion in equipment revenue was wrongly booked. (‘‘Recovering Bonuses Remains Infrequent Despite Emphasis On Corporate Reform,’’ by Joann S. Lublin and Charles Forelle, Staff Reporters of THE WALL STREET JOURNAL, 12 October 2004; p. C1) These examples illustrate that some compensation contracts do not adequately consider the ex post settling up problem. The Sarbanes-Oxley (2002) Act encourages firms to write provisions into compensation agreements requiring executives to return bonuses on restated numbers. LWZ argue that the optimal cash compensation contract will consider the ex post settling up problem and will not be symmetric in gains and losses but instead will give less weight to gains. Consider the following contract: 1.2. Asymmetric contract
Bonus is 5% of increases in firm value (unrealized gain) Bonus is 10% of decreases in firm value (unrealized loss)
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This contract is more sensitive to downside risk. When the CEO signs a lucrative contract and firm value goes up by $100, the CEO receives a bonus of $5. Now, consider what happens in the next period when the contract falls through and the value of the firm drops by $100 (no value was created after all). The bonus is 10% of the decrease in firm value, so the CEO owes the owners $10. If the CEO has resigned in the interim period, it may be difficult for the owners to recover the bonus from the CEO. However, the owners have only lost $5 rather than the $10 they would have lost under the symmetric contract. Thus, the asymmetric payoff function reduces agency costs related to ex post settling up. The asymmetric nature of the contract subjects the CEO to greater risk. Thus, the CEO would probably require a higher expected wage to accept the asymmetric contract. Optimal contracting typically assumes a risk-averse manager and risk neutral owners and the objective of the contract is to provide incentives for the manager to increase firm value, but at the same time shield them from risk. In contrast, this contract exposes the CEO to more downside risk and less upside benefit. LWZ also consider equity incentives (options and restricted stock grants), and suggest that these will have symmetric payoff functions because they have built in safe guards against the ex post settling up problem. In the example above, assume the CEO receives an option grant (at the money) when he signs the lucrative contract in the first period (and increases firm value by $100). In the next period when firm value decreases by $100, his options will be out of the money and so the owners do not lose. If he leaves in the interim and his options have not vested, then the owners also do not lose. 2. Predictions and tests In order to test whether cash compensation contracts (salary and bonus) are asymmetric in expected gains and losses, LWZ first need to obtain a proxy for unexpected gains and losses. Their paper considers various measures of unexpected/expected gain or loss. They suggest that market-adjusted stock returns reflect changes in expectations about future cash flows and so positive returns are indicative of a CEO creating value (unexpected gains), while negative stock returns are indicative of a CEO who has reduced value (unexpected losses). These are called ‘‘good news’’ and ‘‘bad news’’ firms, respectively. LWZ predict that CEO cash pay is more sensitive to stock returns when returns are negative. They set D ¼ 1 when stock returns (R) are negative. They run the following regression (reported in Table 4): D lnðCash Compit Þ ¼ b0t þ bit þ b2 Rit þ b3 DROAit þ b4 Dit Rit þ b5 Dit DROAit þ controls:
ð1Þ
They predict a positive coefficient on b2, b3, and b4 they have no prediction for b5. Specifically, they find a positive coefficient on b4 consistent with cash compensation being more sensitive to negative returns (unexpected losses). This result is robust when the authors use raw returns or industry-adjusted returns. They also regress: D lnðEquity Compit Þ ¼ b0t þ bit þ b2 Rit þ b3 DROAit þ b4 Dit Rit þ b5 Dit DROAit þ controls:
ð2Þ
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They predict that b2 will be positive and that b4 will equal to zero (unfortunately, they predict a null result for b4 which makes interpretation difficult). Their results are consistent with their predictions. LWZ’s results are very interesting and they have done a multitude of tests to ensure that the result is robust. Unfortunately, their cross-sectional tests examining situations where the ex post settling up problem is more severe (such as when the CEO is close to retirement) do not produce significant results, bringing into question whether the ex post story is what is driving their results. LWZ recognize this concern and point out that this suggests that the ex post settling up explanation is a plausible but not compelling explanation for the asymmetry. To summarize, consistent with ex post settling up, the authors find that salary and bonuses (cash compensation) are more sensitive to stock price decreases than to stock price increases. I am confident that this result is robust. Therefore, my discussion will explore alternative potential explanations for their empirical findings. 3. Optimal contracting perspective and the importance of ex post settling up Under optimal contracting theory the objective is to provide incentives for managers to act in the interest of the owners to maximize firm value, while minimizing agency costs. An important consideration therefore is which is a dominant concern for the owners:
Do the owners want to provide incentives to encourage the CEO to take the right action to increase firm value (provide a carrot)? or Do the owners want to penalize the CEO fully and immediately when things go wrong (use a stick)? Consider the type of features included in typical compensation contracts:
Base salary—receive no matter what happens; Bonus—lower bound and upper bound features; Stock options—issued at the money, have zero value when price drops below the exercise price. Can be reissued/repriced when stock prices fall; Restricted stock—payoff when performance metrics are met; Golden parachutes—provide payments to CEOs when company is a target to a hostile takeover.
The features of these contracts appear to be consistent with risk neutral owners providing incentives to limit managers’ downside risk so as to encourage them to take on risky positive net present value projects. Theory suggests that the level of expected compensation needs to be set higher to attract a manager (who has competing job opportunities) to work for a firm that offers incentive compensation (due to the uncertainty of the payoffs). Therefore, by limiting the downside risk, owner can reduce the overall expected pay to the manager. If penalizing CEOs for unexpected losses is of first-order importance, would not we observe contractual features explicitly outlining the asymmetric pay-off function? Ex post settling up is certainly an important problem, but I think it is likely to be of second-order importance in the design of compensation contract. So then, what explains LWZ’s findings? Below I discuss a few alternatives.
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4. The design of compensation contracts 4.1. The bonus contract: the mystery of the non-GAAP earnings number that includes unrealized losses Bonus contracts typically state that the bonus is a percentage of an earnings metric such as return on assets or return on equity. There is usually no explicit mention of stock price performance in these contracts. Yet LWZ are suggesting that the board of directors identify and include unrealized losses (not reflected in GAAP income) in determining the bonus. Where do compensation committees find this number? The basic premise of this prediction seems at odds with results documented in prior research that suggests that boards filter out ‘‘unexpected or unusual’’ negative items in earnings. Dechow et al. (1994) find that non-recurring restructuring charges are filtered out of CEO compensation. They suggest that this is consistent with boards encouraging CEOs to take unpleasant value-enhancing actions that reduce current earnings. Gaver and Gaver (1998) have a more sinister view. They document that losses are filtered out of CEO pay while gains are included in CEO pay. They find that the transitory nature of the item is unimportant. They suggest that CEOs opportunistically lobby the board to filter out losses but not gains from earnings. If CEOs are not penalized for recognized losses in earnings, why would CEOs tolerate the Board penalizing them on a non-GAAP earnings number that includes unrealized losses? Why is this mysterious non-GAAP earnings number not mentioned in proxy statements? Of course, compensation committees could be using their discretion to reduce bonuses even when the target is met. However, there are alternative explanations for this finding. Holthausen et al. (1995, Table 3) provide statistics on how bonuses are set using a proprietary data set that gives details on bonus contracts. They report that the average target bonus is set at 55% of salary and is capped at 88% of salary. The threshold bonus (lower bound) is set at 7% of salary. This is presented graphically in Fig. 1. They point out that the CEO on average makes the target bonus (i.e., targets are set so that the CEO expects to receive a bonus of 55% of salary). The features of the contract indicate that CEO expected pay is set closer to the upper bound. It is not an equal distance from the upper and lower bound. Therefore, as shown in Fig. 1, cash compensation is less sensitive to upside potential because of the greater likelihood of hitting the upper bound. Indjejikian and Nanda (2002) document a similar finding. They report that target bonuses are biased so that they are on average easy to achieve.1 Empirically, this means that more CEO pay observations exceed the target than are below it. In Table 2 of Leone et al. (2005) have more observations with negative market-adjusted returns (5,749) than with positive market-adjusted returns (4,109), suggesting that some of the negative realizations correspond to managers actually beating their bonus targets. In contrast, the positive returns are likely to reflect managers beating their targets and hitting the upper 1 Indjejikian and Nanda (2002) also find that targets are less likely to be adjusted upwards (after a target is exceeded), then downward (after a target is missed). They suggest that this asymmetric adjustment process will create better future incentive alignment for managers who miss their target (although this asymmetric function also appears to be consistent with management opportunism). This asymmetric adjustment is difficult to reconcile with the ex post settling up story.
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100%
Bonus (% Salary)
88% ∆ = 33% 55% Cash compensation less sensitive to upside due to greater likelihood of hitting upper bound
∆ = 48% 7% Lower Bound
Target ROA
∆ ROA= - 5%
Upper Bound ∆ ROA= + 5%
Fig. 1. A typical compensation contract (see Holthousen et al., 1995).
bound, where the slope of the bonus function is zero. Consequently, CEOs with ‘‘bad news’’ are more likely to be in the incentive zone than managers with ‘‘good news.’’2 In summary, a feature of bonus plans is that they are set to be more sensitive to downside risk. Firms that do well are likely to have higher ROA and returns, and are therefore more likely to hit the upper bound. Firms that do poorly have lower ROA and negative returns BUT are less likely to hit the lower bound. In other words the significant coefficient on DR may not be due to Board’s considering unrealized losses (having a mysterious non-GAAP earnings number that includes unrealized losses) when determining the CEOs cash compensation. Compensation committees could be mechanically applying the bonus formula and LWZ could just be documenting this feature of the contract. 4.2. Equity sensitivity to changes in stock prices As shown in Eq. (2), LWZ find that b4 is insignificant and suggest that this implies a symmetric payoff for unrealized gains and losses. They argue that this is consistent with their ex post settling up story. LWZ measure equity compensation as stock options and restricted stock granted during the year. CEOs wealth from stock options is equal to the total value of all his options outstanding (grants plus options that have vested but not expired). The CEO’s sensitivity to stock price movement is equal to the change in value of all the options he owns to a change in price. Fig. 2 provides the payoff function to an option. Executive options are usually granted at the money (exercise price equal to the market price). As can be seen from Fig. 2, when the stock price is close to the exercise price, the change in the value of the option (its delta) is more sensitive to upward movements in stock price than to downward movements in price. 2
Another possibility for the greater sensitivity of bonuses to negative returns relates to the performance metric used in the bonus contract. Compensation committees could sensitize CEO pay to changes in total firm value (debt plus equity). When the CEO increases firm value, his bonus will increase, and the shareholders benefit disproportionately (due to the fixed pay-off function of debt). When the CEO decreases firm value, his bonus will decrease, but the shareholders share some of this decrease in value with debt holders. As a consequence, bonuses would be more sensitive to decreases in stock returns.
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50 45 40
Prior
35 30
Starting point: X =current stock price
25 20 15 10 5 0 0
5
10
15
20
25
30 35 40 Option Value
45
50
55
60
65
70
Fig. 2. Evaluating stock compensation. Stock options granted at current stock prices: implies that option value is much more sensitive to upward changes than to downward changes in price (i.e., D is larger for upward movements).
If LWZ had used the change in the total value of options used in CEO equity compensation rather than grants, then we would expect the coefficient on DR (b4) to be negative (less sensitive to downside stock movements). 4.3. Combining cash and equity compensation and considering total compensation When considering the optimal contract, the objective is to provide incentives for managers to maximize firm value. Stock options and restricted stock provide CEO pay with upside sensitivity (but limit downside risk), the bonus is set to provide the CEO pay with some downside sensitivity (limits the upside benefit). When we combine both components of compensation and analyze total compensation, it appears that contracts are designed to provide a symmetric pay-for-performance sensitivity. This suggests that an alternative explanation for LWZ’s results is that optimal contracts provide both upward and downward risk sensitivity to value, but the sensitivities come from different parts of the overall pay package. 5. Managerial power perspective: outrage and camouflage A growing area of compensation literature investigates an alternative explanation to optimal contracting for the design features in executive compensation. Bebchuck et al. (2002) point out that many features of compensation contracts can be explained in terms of managerial power and rent extraction (skimming). This view argues that CEOs have power to influence their own pay, and they use that power to extract rents subject to two constraints: the outrage factor and their ability to camouflage their pay. Bebchuk et al. (2002, p. 786) note that at some point even the most loyal director will refuse to approve the compensation package, or shareholders may seek to replace the CEO (the outrage factor). However, the outrage factor can only occur when there is widespread recognition that the level of compensation is too high. Bebchuk et al. (2002, p. 788) note that a large extraction of rents will not cause harm if it can be packaged or camouflaged so that it is not
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readily apparent. They argue that compensation consultants help justify large pay packages and certain features of stock options (e.g., providing too many) help with camouflage. The point is that under the management power perspective, one no longer views the board as independent acting in the interest of owners. Instead, the board is happy to satisfy the CEO subject to not causing outrage that can be costly to the directors’ reputation and wealth. Under this view, compensation contracts are designed to give the CEO as many carrots as possible, in ways that do not cause undue scrutiny. An interesting question is how well do the results documented by LWZ fit into this framework? 5.1. Section 162 (m) implications for cash compensation LWZ’s sample consists of firm-years between 1993 and 2003. In the early 1990s, there was a public outcry against ‘‘excessive’’ executive compensation. This resulted in several regulatory changes including the SEC rule change in 1993 requiring enhanced disclosure on executive compensation and the enactment of tax legislation limiting the deductibility of non-performance-related compensation over one million dollars [Section 162(m) of the Internal Revenue Code]. The goal of the new SEC disclosure requirements was to make compensation disclosures clearer and more concise. Congress never intended for Section 162(m) to be a revenue-raising provision, but instead Congress hoped to change corporate behavior. Whether cash bonuses are treated as performance-based depends on a number of factors. Balsam and Ryan (1996) note the following (italics added) To qualify for the performance-based exception under section 162(m), companies must develop a performance-based compensation plan that is based on the executive’s attainment of one or more performance goals that were established exante by a compensation committee composed of independent directors. The performance goals must be based on objective formulae and the material terms of the plan must be disclosed to and approved by shareholders. The compensation committee, which has the discretion to award less, but not more than the objectively determined amount, must certify that the performance goals have been met before payment is made. In other words, if Boards want to include ‘‘unrealized losses’’ or negative news to adjust bonuses down, they can. If they want to include ‘‘unrealized gains,’’ or positive news to adjust bonuses up, they cannot (they have to instead adjust some other part of the compensation package). Therefore, an alternative explanation to the ex post settling up story for the greater sensitivity of cash compensation to ‘‘bad news’’ is that Boards want to be able to claim that the bonus compensation paid to CEOs is ‘‘performance based’’ and tax deductible (perhaps because of outrage concerns). This results in them only having discretion on the downside, due to section 162 (m). Perry and Zenner (2001) point out that the actual dollar cost of losing the tax deductibility of the pay is small and immaterial to many firms. Therefore, one could argue that the cost itself is unlikely to deter extra cash compensation and so section 162 (m) could not be driving LWZ’s results. However, Perry and Zenner (2001, p. 8) state: The Investor’s Business Daily of March 10, 1995 presents some data from a Towers Perrin survey illustrating why firms are concerned about 162(m). The survey reports
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that 87% of the firms surveyed intended to implement 162(m) changes for positive shareholder relations while only 43% of the firms mentioned that financial (tax) considerations were important. LWZ report that the average manager in the sample is paid $1.2 million in cash compensation, with managers of bad news firms paid 1.17 million and managers of good news firms paid 1.4 million. If the $1 million dollars threshold is the number that is likely to cause investor outrage, then many of the Compensation Committees in LWZ’s sample are likely to prefer to substitute away from cash compensation towards equity-based incentives when there is a desire to provide more compensation to the CEO. In other words, outrage concerns over ‘‘excessive’’ cash pay could also act as a cap on CEOs cash pay. This in turn could lead to a less sensitive pay-for-performance relation in the positive stock-return sample. 5.2. Other avenues of research investigation the managerial power perspective for ‘‘bad news’’ firms Paying excessive cash compensation is a very visible performance metric that is not easily camouflaged and is likely to cause considerable outrage when the firm is doing poorly (why is the CEO getting a pay rise while others are losing their jobs!). One way for the CEO to get around this problem is to substitute other forms of pay (airplanes, stock options, gym memberships, etc.) for cash. It is difficult to determine from LWZ’s descriptive statistics (Table 2) whether there is a substitution effect going on for firms with negative stock price performance. Do CEOs of ‘‘bad news’’ firms lose some cash compensation but make it up through larger option grants that are less observable to outsiders? The prior version of the paper (presented at the conference) had a smaller sample size (3,707 firms) and LWZ’s descriptive statistics suggested that cash compensation and equity compensation slightly increased for ‘‘bad news’’ firms but stock compensation increased by a much greater percentage. In this version of the paper (sample size of 9,858) the results present a different picture. It would be interesting to know more about the distribution of the change in equity and cash compensation for the ‘‘bad news’’ firms. In what proportion of the firms does there appear to be substitution of equity compensation for cash compensation and are these firms most likely to be subject to outrage? It would also be interesting for LWZ to investigate whether CEOs whose cash compensation is most sensitive to negative stock price performance are ones where ‘‘outrage costs’’ are high (perhaps firms that are already under scrutiny by the media or investor advocate groups). Another interesting extension would be to examine whether board composition affects the relation. For example, are firms in which the CEO has significant power over the board, more likely to substitute equity compensation for cash compensation when the firm is doing poorly? 6. Conclusion Leone et al. (2005) identify an interesting empirical fact. They find that after controlling for earnings, cash compensation is more sensitive to negative stock returns than to positive stock returns. This result is consistent with their prediction that the pay-for-performance relation is stronger for ‘‘bad news’’ firms because of the ex post settling up problem.
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My discussion takes this result as ‘‘given’’ and considers alternative explanations for their findings. I question whether the ex post settling up problem is of first-order importance in explaining the authors’ findings. Optimal contracting theory suggests that (risk neutral) owners want to provide incentives to (risk averse) managers to maximize firm value, subject to minimizing agency costs. In order to align the manager’s interest, the owners want to provide incentives that encourage managers to take actions to maximize firm value. The optimal compensation contract will typically include several components to achieve this goal. Bonus contracts appear to be designed to provide executives with limited upside and more downside risk, while equity contracts appear to be designed to give executives limited downside and more upside risk. Taken together, this suggests that total executive compensation is sensitive to both upward and downward movements in value. The source of the sensitivity is just derived from different components of the package. I also explore the managerial power perspective (e.g., Bebchuk et al., 2002). In the early 1990s, public outrage over excessive executive compensation resulted in two major regulatory changes. First, in 1994 the SEC required more disclosure of compensation. Second, Congress passed rule 162 (m) that made non-performance based compensation over one million dollars non-tax deductible. The motivation for this legislation was to encourage more pay-for-performance. I discuss several reasons why this legislation is likely to cause a stronger pay-for-performance relation for the ‘‘bad news’’ firms. In summary, this is a very interesting and thought-provoking paper that opens a number of opportunities for future research. References Balsam, S., Ryan, D., 1996. Limiting executive compensation: the case of CEOs hired after the imposition of 162(m). Working Paper, Temple University. Bebchuck, L.A., Fried, J.M., Walker, D.I., 2002. Managerial power and rent extraction in the design of executive compensation. The University of Chicago Law Review 69, 751–846. Dechow, P., Huson, M., Sloan, R., 1994. The effect of restructuring charges on executives’ cash compensation. Accounting Review 69, 138–156. Gaver, J.J., Gaver, K.M., 1998. The relation between nonrecurring accounting charges and CEO cash compensation. The Accounting Review, 235–253. Holthausen, R., Larcker, D., Sloan, R., 1995. Annual bonus schemes and the manipulation of earnings. Journal of Accounting and Economics 19, 29–74. Indjejikian, R.J., Nanda, D.J., 2002. Executive target bonuses and what they imply about performance standards. The Accounting Review 77 (4), 793–819. Leone, A., Wu, J., Zimmerman, J., 2006. Asymmetric sensitivity of CEO cash compensation to stock returns. Journal of Accounting and Economics 42, 167–192. Perry, T., Zenner, M., 2001. Pay for performance? Government regulations and the structure of compensation contracts. Journal of Financial Economics 62, 453–488.